Question

POSITIVE ACCOUNTING THEORY

Jimmy is the owner of VRS Pty Ltd. Until recently, Jimmy was also the managing director, but he has decided to employ a manager to take over the daily operations of VRS as he transitions to retirement. The new manager, Beryl, agreed to a performance based contract which says that Beryl will be paid a bonus of $200,000 should the profits exceed a target of $2 million. The contract also says that Beryl must prepare financial statements and have them audited. Briefly define agency theory. According to agency theory, what are the roles performed by Jimmy and Beryl?

Answer 1

1- Breifly define Agency theory -   Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents.

• Agency theory attempts to explain and resolve disputes over priorities between principals and their agents.
• Principals rely on agents to execute certain transactions, particularly financial, resulting in a difference in agreement on priorities and methods.
• The difference in priorities and interests between agents and principals is known as the principal-agent problem.
• Resolving the differences in expectations is called "reducing agency loss."
• Performance-based compensation is one way that is used to achieve a balance between principal and agent.

Understanding Agency Theory

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf.

2- According to the agency theory what are the roles performed by owner and manager -

The relationship between business owners and business management gets complicated when they're not the same people. One approach to understanding it is agency theory: Managers are agents for the owners and are obligated to represent their best interests. Types of agency problems arise when managers' self-interest conflicts with that of the owners.

Agency theory provides a framework for determining the appropriate contractual arrangement (implicit or explicit) that aligns the interests of a principal and an agent who are engaged in a co-operative activity in the presence of hidden action and hidden information which the principal cannot observe or can do so at a cost, but may still not be able to prevent opportunistic behaviour by the agent.

An agent performs a function on behalf of another person, the principal. A principal – agent relationship arises in various spheres of human interaction and endeavour. Examples of agency relationships include that between an employer (principal) and an employee (agent), a lawyer (agent) and his client (principal), an agricultural landowner (principal) and a sharecropper (agent), to give a few examples in private settings.

The agent represents the principal in a particular business transaction and is expected to represent the best interests of the principal without regard for self-interest. The different interests of principals and agents may become a source of conflict, as some agents may not perfectly act in the principal's best interests. The resulting miscommunication and disagreement may result in various problems and discord within companies. Incompatible desires may drive a wedge between each stakeholder and cause inefficiencies and financial losses. This leads to the principal-agent problem.